Chicken Little and the Financial Crisis

The pipe dream of all investors is to achieve attractive investment return with little or no risk. Some financial firms capitalize on this dream by shaping their marketing campaigns accordingly. The implication is that the firm has the expertise to identify forthcoming market declines—the new catchphrase is “market bubbles”—and to guide investors safely through periods of market distress. Often, this boils down to promoting a best-investments-to-own-now sales pitch.

“Risk premiums on both equities and bonds increase substantially in response to the crisis conditions. In the crisis scenarios we considered, we found that equity premiums increase by 25%-35% and bond risk premiums generally increase by 7%”

Of course, market timing has been so thoroughly discredited that few claim that they pursue this investment strategy. The new financial product and services marketing mantra introduces investors to experienced professionals who identify “investment themes” and provide “narratives” regarding how to “position” a portfolio to “adapt” dynamically to a fast-changing and complex environment. Several recent exposés by the independent financial press help investors decipher these marketing narratives—“you’re probably gullible enough to allow us to increase your portfolio turnover in the unjustified expectation that our firm can outwit the market and can deliver profits to you after taxes, commissions and other costs.” For example, the recent PBS Frontline TV program [“The Retirement Gamble”] documents the campaigns to win clients by promulgating dubious investment advice and questionable practices. For readers interested in a well-researched book, we recommend Pound Foolish: Exposing the Dark Side of the Personal Finance Industry by Helaine Olen.

Nevertheless, the easy response—they’re all a bunch of crooks—still leaves unanswered the big question: what should investors do when confronted with an extreme market decline? A recent study explores this very question: “Flight to Quality and Asset Allocation in a Financial Crisis,” by Professor Terry Marsh of UC Berkeley and Professor Paul Pfleiderer of Stanford (we did not know such collaboration was possible!). It appears in the July/August 2013 edition of Financial Analysts Journal. Specifically, they seek to quantify the appropriate tactical response for investors suffering portfolio losses in the midst of a major market disruption.

They begin with the observation: “Perhaps the most natural response to a crisis, at least for many investors, is to ‘flee to safety’ as confidence in the market erodes and prospects appear to dim, especially for equities.” However, they also note: “… an investor who flees to safety must convince another investor to take the other side of his trade and ‘flee’ to increased risk. Thus, only a subset of investors can flee to safety.” Stated otherwise, assuming all tradable wealth is equally divided between risk averse and risk tolerant investors, for anyone wishing to make a change in one direction, there must be someone willing to make the same change in the opposite direction.

In a financial crisis, “… asset prices must adjust so that a substantial number of investors find it in their interest to hold risky assets despite the increased uncertainty in the economy. Indeed, market clearing essentially requires that the ‘average’ investor be willing to hold the available assets, including risky assets, in roughly their market proportions …” Risk averse investors will want to decrease their holdings of risky assets; risk tolerant investors will want to increase portfolio risk in the expectation of capturing higher future returns. Here’s the key point: at any point in a crisis, the risk/return tradeoffs offered in the marketplace must reflect the desire of all market participants to adjust their portfolio risk either up or down. As more investors wish to flee to safety, the risk/return tradeoff expectations must become increasingly attractive to induce a sufficient volume of counterparty interest.

The article discusses multiple models reflecting various assumptions regarding the dispersion of risk tolerance among investors. No model is based specifically on the 2008-2009 global recession. Rather, the authors develop the mathematics for a more general model applicable for use within any period of financial turbulence. The base case financial crisis model assumes that equities decline in value by 40% and bonds by 10%. Additionally, it assumes that price volatility and return correlations increase substantially.

Rather than focusing on model structure, suffice it to say that a market crisis causes complex interactions. For example, the decline in asset prices has a greater impact on the subpopulation of risk tolerant investors because, relative to more conservative investors, the risk tolerant group suffers a greater proportional decline in wealth simply because they hold more risky assets: “the distribution of wealth will shift toward the less risk tolerant.” When measured across the entire investor population, this causes the average or representative investor’s risk tolerance to decrease. In a bear market, this decrease in average risk tolerance has a number of effects. It decreases general investor demand for risky assets, drives down the price of risky assets as investors flee to safety, and increases the expected future reward for acquiring risky assets. Pfleiderer and Marsh found that, “risk premiums on both equities and bonds increase substantially in response to the crisis conditions. In the crisis scenarios we considered, we found that equity premiums increase by 25%-35% and bond risk premiums generally increase by 7%.” Note: the risk premium is the expected future reward (return above the risk-free rate) for holding a risky asset.

Given crisis conditions, the optimal portfolio adjustment by any individual investor depends on whether his risk tolerance is greater or lesser than that of the average or representative investor. However, any adjustments must be consistent with the laws of supply and demand. “In a crisis, prices and risk premiums must adjust so that, as a rough approximation, one can say that the ‘average investor’ will not want to trade. The trades that any particular investor will want to make depend on how that investor’s risk preferences and other characteristics compare with those of the average investor.”

Bottom Line: “One of our key observations is that the appropriate tactical responses for most investors in a crisis can actually be rather small. In our base case with no differences in investor expectations, we found that for 80% of the investors, the appropriate adjustment involves less than 4% turnover … only investors who are extremely risk averse or risk tolerant will find it appropriate to make significant changes in their allocations.” In just about all model variations, the optimal portfolio asset turnover is less than 10%.

Consider the implications of this study when you next hear the TV commentator exhort you to sell your portfolio because only a 100% cash position will save you from economic disaster.

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